Economic Perspective

A Monthly Commentary

^{January 2012}

The U.S. economy appeared to be back on track entering 2011 but succumbed to the Japanese earthquake, European debt crisis and partisan gridlock in Congress exemplified by the debt-ceiling fight during the summer and payroll tax cut extension battle in December.  So, while it is prudent to be cautious this year, we believe that the U.S. economy will find firmer footing.  The major impediments to growth are mostly the same – debt concerns leading to a potential recession in Europe, an inability in Congress to adequately address government spending and a slowing pace of growth in China and India. 

What is different this time?  Progress has been made on a number of important fronts and markets have adjusted to account for the headwinds.  The ECB has stepped in with its Long Term Repo Operation (LTRO) for the European banks who have borrowed $578 billion to date. This is in addition to the Federal Reserve’s central bank liquidity swap facility to help provide dollar liquidity to overseas banks.  Automatic spending cuts in the U.S. will kick in should Congress fail to reach an agreement.  The Eurodollar is falling providing stimulus to the European economy and easing inflationary pressures.  In addition, monetary authorities are cutting interest rates globally.  Low interest rates should lend support to a growing economy as banks clean up their balance sheets and become more comfortable lending.  In fact, lending to small businesses has picked up recently.  Also, a positively sloped yield curve, as we are currently experiencing, is typically a leading indicator of economic improvement.

The U.S. economy exited the 4th quarter with momentum building.  Employment increases have now persisted for over two years.  Unemployment claims are falling and ISI company surveys of business activity have been rising.  Vehicle sales are rising steadily, consumer confidence is picking up and manufacturing and purchasing indexes in the U.S., Europe and Asia are gradually improving.  Railcar loadings and rig counts have been showing consistent growth and credit card delinquencies have declined throughout 2011.  Consumer spending has shown resilience driven in part by a slowdown in inflation from 4% during the summer to 3% currently.  Even home prices are stable or rising in some regions with a pick up in November pending home sales and December existing house sales.  U.S. home construction, surprisingly, rose to the highest level in 19 months during November.

This has led to strong corporate earnings as companies pare costs creating lean operations that are highly leveraged to small increases in revenues.  For the 3rd quarter, 73% of all S&P500 companies beat expectations and earnings grew 15.7% in aggregate making it the 7th consecutive quarter of double-digit growth.  Expectations are for 4th quarter GDP to growth in the 3-4% range and S&P500 earnings to grow 8%.  Companies with strong balance sheets are using cash to buy back stock and insider buying has been picking up.

Market valuation also continues to be a positive both relative to historical levels and in relation to bond yields.  The S&P500 is trading at a price earnings multiple of 12.5 versus an average of 20.2 over the past 20 years.  The yield on the S&P500 is 8% versus the 10yr Treasury note at 1.95%, a record spread.  We also take some comfort in the fact that U.S. markets last year outperformed almost all major world markets.  Given that stocks generally lead the economy by 6-12 months, the U.S. market outperformance last year suggests that the economy is not likely to slip into a double dip recession.

Although the economy is healing, any of a number of roadblocks could resurface to drag growth down again, particularly with business sentiment in a very fragile state.  A key area of concern is the European debt refinancings that will be ongoing throughout the year.  If sovereign debt is replaced at reasonable rates, markets will likely be reassured.  A March summit of European leaders will be closely watched as will the French presidential elections in April and May. Europeans need to make significant progress in controlling government spending, easing constraints on labor and addressing welfare reforms or European malaise will constrain growth in the rest of the world.  

Growth in China is slowing to rates that approach stall speed in terms of job growth, industrial investment and consumer spending.  If growth should continue to slow, its impact would be felt in the West.  In February, Congress will again discuss the expiring payroll tax cuts which if not dealt with will cause stock sentiment to sour.  The rating agencies could at any time grow tired of the pace of progress on debt reduction and further downgrade sovereign debt.  Additional problems for the market include political upheaval in the Middle East and Africa, further resolution of Federal and State deficits, mortgage debt, rising healthcare costs and consumers with excessive debt.  Given these headwinds, we think it makes sense to be a bit cautious about stocks near term.

Although the market faces a number of headwinds, the evidence in total points to better growth as we begin the New Year.  We will likely see further gyrations as we climb our way out of a period of sluggish growth and back to more typical economic recovery led by strong corporate earnings, a stabilizing job market and slowly healing housing industry.  We expect, therefore, to see improved market conditions fairly soon. 

Frederick J. Linkner, CFA
Director of Research

Frederick J. Linkner, director of research, presents a comprehensive analysis of the economy including sectors, interest rates, currencies, GDP growth and how these might effect Rosenblum Silverman Sutton investment decisions.